Definition: Open market operations (OMO) is an economic monetary policy where central banks purchase or sell bonds or other government securities on the open market in an effort to regulate the money supply. In other words, the Federal Reserve Bank buys bonds from investors or sells additional bonds to investors in order to change the number of outstanding government securities and money available to the economy as a whole.
What Does Open Market Operations Mean?
The FED exercises direct purchase or sale of government bonds to regulate liquidity and credit conditions through the Federal Open Market Committee (FOMC).
OMO are instruments of monetary policy because they can directly influence the supply of money in the market. If the FED seeks money supply growth, it buys government bonds. Thus, channeling money in the market. Conversely, if the FED seeks to restrict money supply, it sells the government securities and borrows money from commercial banks.
Based on their occurrence and the procedures applied, open market operations are classified into four distinct categories:
- Core refinancing operations – provide liquidity through reverse transactions
- Longer-term refinancing operations – provide liquidity through reverse transactions
- Fine-tuning operations of short-term liquidity fluctuations – primarily reverse transactions, but they can also take the form of an outright transaction, foreign-exchange swap or collection of fixed-term deposits
- Structural operations – provide liquidity through reverse transactions and can take the form of an outright transaction or the issuance of a debt certificate.
Let’s look at an example.
The Fed decides to buy government bonds to boost money supply in the market. Following this transaction, the interest rates drop from 5% to 4%.
How will this affect Mary who wants to take out a new loan?
Because the interest rates are lower, Mary can take a home equity loan at a lower rate. The Fed’s decision to supply money in the market through an open market transaction lowers the price of money, thus facilitating consumer and business borrowing. New loans and credit cards are now cheaper to acquire. As more people take on new loans, spending increases and the economy is strengthened.
How will this affect Mark who has a savings account?
Because the interest rates are lower, Mark earns less on his savings account. Consequently, his income is lowered and he reduces his spending. Therefore, for savers, an open market operation is not favorable. It tends to turn them into investors because their savings will earn them very little interest.